It was a great year for stock market returns. According to data from Morningstar, as of Dec. 24 stocks representing the U.S. market returned 13.95 percent. Morningstar's intermediate core bond index returned 5.16 percent over the same period.
Even with disappointing returns in European and emerging markets, if you held a diversified portfolio, you likely would have reaped commendable results this year, depending upon your allocation to stocks.
Unfortunately, if you are like many investors, your returns lagged the indexes. Here are some of the possible reasons. Knowing them can help you avoid making the same mistakes in the future.
You bounce in and out of the market
All we really know about the direction of the market is that it goes up and down, but over long periods of time it increases in value. I have seen no credible data indicating anyone has the expertise to predict the direction of the market in the short term. Unfortunately, the financial media encourages the belief that its pundits have just this ability.
Missing just a few days in the market can have a very significant impact on your returns. For example, the S&P 500 index had an annualized return of 9.2 percent from 1993 to 2013. All you had to do to achieve those returns (net of fees) was to buy a low management fee index fund that tracked the S&P 500 and then hold on to it.
However, if you missed just the 10 best days of stock market returns during that period, your annualized return would have been only 5.49 percent.
You trade excessively
Buying and selling stocks and bonds increases transaction costs. In general, the higher your transaction costs, the lower your returns (but the happier your broker) will be.
Intelligent and responsible investing does not involve stock picking or market timing. It does include determining your asset allocation and then investing in a portfolio consisting of low management fee index funds, exchange-traded funds and passively managed funds. The only time you should initiate transactions is when they are necessary for rebalancing your portfolio to keep your risk profile intact or to change your asset allocation due to a life event (like an inheritance, death or divorce).
You buy actively managed funds
Trying to pick a fund manager who will outperform the market is a risk you should not take. The sad story of Michael Aronstein should give you pause.
According to the Financial Times, Mr. Aronstein's MainStay Marketfield fund took in more money from investors than any other U.S. mutual fund in 2013. The fund is a "liquid alternative" fund, which has broad discretion to take "hedge fund like bets" across the financial markets.
Notwithstanding Mr. Aronstein's stellar reputation as a star fund manager, the fund is down 13 percent year-to-date. Many clients are seeking redemptions.
According to financial journalist Rick Ferri, over a five-year period, approximately 25 percent of actively managed mutual funds will outperform their benchmark, 25 percent will modestly underperform and 25 percent will underperform by a significant amount. What about the other 25 percent? They will go out of business.
Your broker will go to great lengths to keep you from understanding how investing in an actively managed stock or bond fund is likely to be harmful to your financial well-being. Now that you know the facts, don't be fooled.
Your misguided belief in a "magical" portfolio
I am aware of no credible evidence supporting the belief in a "magical" portfolio that will allow you to capture the returns of a bull market and protect you in a bear market. In the recession of 2008, even broadly diversified portfolios suffered meaningful losses.
Instead of seeking a portfolio that doesn't exist, focus on factors you can control, such as keeping your costs and fees low, broad diversification and tax efficiency. Also, take a hard look at your asset allocation (the division of your portfolio between stocks and bonds). If your time horizon is less than three years, you should consider having no exposure to stock market risk.
There is a major difference between an investor and a speculator. Much of the financial media encourages speculation because the securities industry profits when you purchase high-commission investment products and increase trading.
As an investor, you should position your portfolio so that short-term market volatility is irrelevant. Your focus should be on the long term.
The biggest mistake investors made in 2008 and 2009 was listening to "experts" who predicted a worldwide collapse. These investors dumped their stocks and "fled to safety," thereby missing out on one of the greatest bull runs in stock market history.
You use a "market-beating" broker
The securities industry makes money in up-and-down markets. The financial interests of brokers who claim an ability to beat the markets are in conflict with yours. Your broker is not a fiduciary, meaning he can recommend investments that, while "suitable," are not in your best interest. I continue to be mystified about why anyone would use a broker held to this lower standard when they could retain the services of a Registered Investment Advisor who is required to act solely in your best interest.
Here's my litmus test when interviewing both brokers and Registered Investment Advisors. Ask them this question: Do you have the ability to beat the market by engaging in stock picking, market timing or selecting fund managers who can outperform their peers?
If the answer to this question is "yes," run for the door and don't look back.
Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is The Smartest Sales Book You'll Ever Read.
The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.